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1. This question will ask you to use the Specific factor model to analyse how a change in the relative price of textiles and IT services affects income inequality. Assume that there are two consumption goods: textiles and IT services. There are three production factors in this economy: unskilled workers, skilled workers and capital. Assume that unskilled workers can only work in the textile sector and skilled workers can only work in the IT services sector, while capital can work in both sectors. Assume furthermore that the country we analyse is small.

a) Derive and draw the Product Possibility Frontier (PPF) for textiles and IT services in the economy. Explain your answer.

b) How is the optimal allocation of capital between the two sectors determined under autarky? Explain your answer.

c) Assume now that the country opens up to trade. We assume that the global relative price of textiles in terms of IT services is lower than the autarky relative price in the country we analyse. How does this affect the allocation of capital in the country? Explain your answer.

d) What will the pattern of trade be for the country? Explain your answer.

e) Derive and describe the effect of trade on the real wage of unskilled and skilled workers. What is the effect of trade on income inequality? Explain your answer.

f) If you compare the Specific factor model with the Heckscher Ohlin model, which model would you say is best at explaining short term effects and which is best at explaining long term effects? Explain your answer. )